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Economics

Arbitrage the unfair advantage

If you had enough money to pay off your mortgage right now, would you? Many people would. In fact, the ‘American Dream’ is to own your own home, and to own it outright, with no mortgage. If the American Dream is so wonderful, how can we explain the fact that thousands of financially successful people, who have more than enough money to pay off their mortgage, refuse to do so.

The answer most of what we believe about mortgages and home equity which we learned from our parents and grandparents, is wrong. They taught us to make a big down payment, get a fixed rate mortgage, and make extra principle payments in order to pay off your loan as early as you can. Mortgages, they said, are a necessary evil at best. The problem with this rationale is it has become outdated. The rules of money have changed. Unlike our grandparents, we will no longer have the same job for 30 years. In many cases people will switch careers five or six times. Also, unlike our grandparents, we can no longer depend on our company’s pension plan for a secure retirement. A recent Gallup survey showed that 75% of workers want to retire before the age of 60, yet only 25% think they can.

Unlike our grandparents, we will no longer live in the same home for 30 years. Statistics show that the average homeowner lives in their home for only seven years. And unlike our grandparents, we will no longer keep the same mortgage for 30 years. According to the Federal National Mortgage Association, or Fannie Mae, the average American mortgage lasts 4.2 years. People are refinancing their homes every 4.2 years to improve their interest rate, restructure their debt, remodel their home, or to pull out money for investing, education or other expenses. Given these statistics, it’s difficult to understand why so many Americans continue to pay a high interest rate premium for a 30-year fixed rate mortgage, when they are likely to only use the first 4.2 years of the mortgage. We can only conclude they are operating on outdated knowledge from previous generations when there were few options other than the 30 year fixed mortgage. Wealthy Americans, those with the ability to pay off their mortgage but refuse to do so, understand how to make their mortgage work for them.

They go against many of the beliefs of traditional thinking. They put very little money down, they keep their mortgage balance as high as possible, they choose adjustable rate interest-only mortgages, and most importantly they integrate their mortgage into their overall financial plan to continually increase their wealth. This is how the rich get richer. The game board is the same, but while most Americans are playing checkers, the affluent are playing chess.

Many people hate their mortgage because they know over the life of a 30 year loan; they will spend more in interest than the house cost them in the first place. To save money it becomes very tempting to make a bigger down payment, or make extra principal payments. Unfortunately, saving money is not the same as making money. Or, put another way, paying off debt is not the same as accumulating assets. By tackling the mortgage pay-off first, and the savings goal second, many fail to consider the important role a mortgage plays in our savings effort. Every dollar we give the bank is a dollar we did not invest. While paying off the mortgage saves us interest, it denies us the opportunity to earn interest with that money.

What do you think the rate of return on home equity was in Seattle for the last 3 years? What about Portland? Careful, this is a trick question. The truth is, it doesn’t matter where you live or how fast the homes are appreciating, the return on home equity is always the same, ZERO. We have a misconception that because our home appreciates, or our mortgage balance is going down, that the equity has a rate of return. That’s not true. Home equity has NO rate of return. Home values fluctuate due to market conditions, not due to the mortgage balance. Since the equity in the home has no relation to the home’s value, it is in no way responsible for the home’s appreciation. Therefore, home equity simply sits idle in the home. It does not earn any rate of return.

Assume you have a home worth $100,000 which you own free and clear. If the home appreciates 5%, you own an asset worth $105,000 at the end of the year. Now, assume you had separated the $100,000 of home equity and placed it in a safe, conservative side account earning 8%. Your side account would be worth $108,000 at the end of the year. You still own the home, which appreciated 5% and is worth $105,000. By separating the equity you created a new asset which was also able to earn a rate of return. Therefore, you earned $8,000 more than you would have if the money were left to sit idle in the home.

Homeowners would actually be better off burying money in their backyards than paying down their mortgages, since money buried in the backyard is liquid (assuming you can find it), and its safe (assuming no one else finds it). However, neither is earning a rate of return. It’s actually losing value due to inflation. Few people today bury money in the back yard or under their mattresses, because they have confidence in the banking system. They also understand idle money loses value while invested money grows and compounds. As Albert Einstein said, “The most powerful force in the universe is compound interest.” After all, homes were built to house families, not store cash. Investments were made to store cash. Taken from another angle suppose you were offered an investment that could never go up in value, but might go down how much of it would you want? Hopefully none. Yet, this is home equity. It has no rate of return, so it can never go up in value, but it could go down in value if the real estate market declines or the homeowner experiences an uninsured loss (e.g. earthquake), or a foreclosure. After all it’s better to have the money and not need it than to need the money and not be able to get at it.